Hedge Funds Trail Stocks by the Widest Margin Since 2005

Billionaire Stan Druckenmiller, who produced annual returns averaging 30 percent for more than two decades, last month called the industry’s results a “tragedy” and questioned why investors pay hedge-fund fees for annual gains closer to 8 percent. Photographer: Peter Foley/Bloomberg

Dec. 6 (Bloomberg) -- The $2.5 trillion hedge-fund
industry, whose money managers are among the finance world’s
highest paid, is headed for its worst annual performance
relative to U.S. stocks since at least 2005.

The funds returned 7.1 percent in 2013 through November,
according to data compiled by Bloomberg. That’s 22 percentage
points less than the 29.1 percent return of the Standard &
Poor’s 500 Index, with reinvested dividends, as markets rallied
to records.

“It has been difficult for hedge funds on the short
side,” said Nick Markola, head of research at Fieldpoint
Private, a $3.5 billion Greenwich, Connecticut-based private
bank and wealth-advisory firm. “Funds were defensively
positioned. Central bank action did bode well for equities and
made for a more challenging environment for hedge funds.”

Hedge funds, which stand to earn about $50 billion in
management fees this year based on industrywide assets, are
underperforming the benchmark U.S. index for the fifth year in a
row as the Federal Reserve’s economic stimulus program pushes
equity markets higher. Billionaire Stan Druckenmiller, who
produced annual returns averaging 30 percent for more than two
decades, last month called the industry’s results a “tragedy”
and questioned why investors pay hedge-fund fees for annual
gains closer to 8 percent.

“We were expected to make 20 percent a year in any
market,” Druckenmiller, 60, said in a Bloomberg Television
interview on Nov. 22, referring to veteran managers such as
Michael Steinhardt, Julian Robertson, Paul Tudor Jones and
George Soros. “If the market went down more than 20 percent, we
were expected to make more.”

Government Intervention

The industry traditionally charges clients fees of 2
percent of assets and 20 percent of profits, sometimes with
discounts for big investors. Actively managed U.S. stock mutual
funds average 1.3 percent expense ratios, according to
Morningstar Inc. Such managers averaged gains of 31 percent this
year through last month, Morningstar said.

Hedge funds posted a 0.2 percent gain in November,
according to the Bloomberg Global Aggregate Hedge Fund Index.
They’ve underperformed the S&P 500 by 97 percentage points since
the end of 2008. Some managers cite government intervention in
markets, record low interest rates, declining trading volumes
and assets moving in unison as reasons for limiting their
ability to outperform.

Worst Showing

Bloomberg’s index started tracking hedge funds in February
2005. According to Hedge Fund Research Inc., the industry had
its worst showing relative to the S&P in 1998, when Long Term
Capital Management LP was bailed out by its lenders as Russia
defaulted on its debt, roiling markets.

The HFRI Fund Weighted Composite Index, which is
underperforming the S&P 500 by 20.8 percentage points this year
through November, trailed the equities benchmark by 26
percentage points in 1998, according to Chicago-based HFR, which
has tracked data going back to 1990.

Hedge funds last beat U.S. stocks in 2008, when they lost a
record 19 percent, according to data compiled by Bloomberg, and
the S&P 500 declined 37 percent. They outperformed the index by
the most when they returned 31 percent in 1993, HFR’s data show,
compared with a 10 percent increase for the S&P.

Comparisons with stocks are off-base because hedge funds
have different goals, said Eric Siegel, who oversees $3.5
billion in hedge-fund investments at New York-based Citigroup
Inc.’s private bank.

‘Huge Misunderstanding’

“It’s a huge misunderstanding,” Siegel said. “Not all
hedge-fund clients are looking for super-high-octane returns.
They’re looking for high-quality returns that have lower levels
of risk” over a three-to-five-year investment cycle.

Marc Lasry, who runs New York-based Avenue Capital Group
LLC, said at a September conference that hedge-fund investors
should compare net returns with the risk-free rate of return.
That would be similar to three-month U.S. Treasury bills, which
are currently returning 0.06 percent.

“I think guys who are doing 10 percent are doing a
phenomenal job but then we’re getting compared to the S&P that’s
up roughly 20 percent,” he said.

Moreover, the hedge-fund managers can trade in all markets,
placing wagers on everything from corporate bonds to the yen to
the price of corn. They also use derivatives and other complex
tools, as well as short selling, or betting against securities,
to seek profits and protect against market declines. In a short
sale, a trader sells borrowed assets to bet on a decline, hoping
to buy them back later and pocket the price difference.

Trailing Vanguard

Bonds fell 1.5 percent this year through November, as
measured by the Barclays U.S. Aggregate Index, and the S&P GSCI
gauge of commodities declined 3.1 percent. While hedge funds
have beaten bonds and commodities, they have fallen short of the
$21.2 billion Vanguard Balanced Index Fund, which returned 16
percent through November with 60 percent of assets in equities
and 40 percent in fixed income. The fund’s institutional share
class carries an expense ratio of 0.08 percent, according to
Morningstar.

Fixed income was the weakest hedge-fund strategy this year,
losing 10.4 percent, while credit-arbitrage, which seeks to
profit from price differences between credit markets, was the
strongest, gaining 12.9 percent, according to data compiled by
Bloomberg. Equity long-short funds, which bet on rising and
falling stocks, returned 9.4 percent, and funds which place
wagers on rising markets gained 8.4 percent, according to the
data, which is based on a survey of 2,317 funds, of which 1,183
have reported returns through November.

Some funds again struggled to keep up with the S&P in
November, when the index returned 3 percent.

Renaissance, Tudor

Renaissance Technologies LLC, the $25 billion investment
firm founded by Jim Simons and based in New York, rose 1.1
percent in November in its $9 billion Renaissance Institutional
Equities Fund, making returns this year 18 percent, according to
a person briefed on the gains, asking not to be identified
because the fund is private.

Tudor Investment Corp., the $13.4 billion macro hedge-fund
firm run by Jones, climbed 3.7 percent in November in its Tudor
BVI Global, bringing gains to 12 percent in 2013, a person
familiar with the matter said.

Pershing Square

Pershing Square Capital Management LP, the $12.1 billion
activist hedge-fund firm run by Bill Ackman, posted a 1.2
percent net gain in its main strategy in November, according to
a performance update obtained by Bloomberg News. Pershing Square
International’s monthly return brings its year-to-date advance
to 9.4 percent. The fund has $5.1 billion in assets.

Bridgewater Associates LP, the $150 billion firm run by Ray
Dalio and based in Westport, Connecticut, posted a 0.1 percent
gain in its $16 billion Pure Alpha I fund, bringing this year’s
return to 4.1 percent, according to a person briefed on the
results. Pure Alpha II, with $64 billion, increased 0.1 percent
in November and 6.1 percent in 2013.

Lee Ainslie’s $9 billion New York-based Maverick Capital
Management LP posted a 1.9 percent gain in November in Class A
shares of Maverick Fund Ltd., which rose 13 percent this year,
according to an investor update.

Boaz Weinstein, who runs Saba Capital Management LLC, lost
0.3 percent in November and 1 percent year-to-date in his main
credit fund after losing 3.9 percent in 2012, according to
investors. His New York-based firm oversees about $4 billion.

Spokesmen for the fund companies declined to comment on the
returns.

Shutting Down

As some managers struggled to make money, others chose to
leave the business.

Talal Shakerchi, whose London-based Meditor Capital
Management Ltd. has $3 billion in assets, said yesterday that he
is shutting the firm’s European equity fund, citing an internal
review and new rules restricting short-selling.

Arvind Raghunathan’s New York-based Roc Capital Management
LP, the largest startup hedge-fund firm of 2009, liquidated its
main fund in July after losses. Jeff Vinik, the former Fidelity
Investments stock picker turned hedge-fund manager, told clients
in May that he was returning their capital after performance at
his Vinik Asset Management LP slumped since July 2012.

Hedge funds thrived during the 1990s, posting gains every
year. They developed a reputation for gaining ground whether
markets rose or fell, targeting absolute return rather than
performance relative to a benchmark.

‘Gradual Erosion’

As funds grew, their performance hewed closer to that of
stocks, blunting one selling point: returns that aren’t
correlated with equity markets. Correlation of the HFRI index to
the S&P 500 rose to 0.84 in the five years through October from
0.81 before the financial crisis, according to HFR. The measure
shows how often the two indexes rise and fall together; a value
of 1 means they move in lockstep.

At the turn of the century, managers proved their worth
again when they made money for clients as global equities
slumped in 2000 and 2001 amid the collapse of technology stocks
and the al-Qaeda terrorist attacks on the U.S.

Since then, as industry assets quadrupled and the number of
hedge funds almost doubled, managers have mostly trailed the S&P
500.

“As competition in the industry heated up along with a
changing investor base, which doesn’t want volatile returns,
we’ve seen a gradual erosion of out-performance,” said Francis
Frecentese, New York-based global head of hedge fund research at
Lyxor Asset Management Inc. “As such, conversations with some
managers have implicitly and explicitly switched to their
ability to generate relative returns.”

Higher Deposits

The mixed performance hasn’t dissuaded investors. Clients
added $53.2 billion to the industry in the first nine months of
the year, compared with $34.4 billion for all of 2012, according
to HFR, as consultants emphasize individual managers’ risk-adjusted returns, which incorporate the amount of risk taken to
generate profits.

“You are not going to make money talking about risk-adjusted return and diversification,” Druckenmiller, who closed
his hedge-fund firm three years ago and now manages his own
capital, said in the TV interview. “You’ve got to identify the
big opportunities and go for them.”